Internal and External Causes of Inflation, and Whether Exchange-Rate Policy Is Best for Price Stability

Answer

Part (a)

Inflation is a sustained rise in the general price level, measured by the percentage change in the Consumer Price Index. As a small, open and resource-poor economy operating near full capacity, Singapore faces inflationary pressure from both external and internal sources, on both the demand and supply sides.

External cause 1 — imported (cost-push) inflation. Singapore imports most of its raw materials — commodities, food, untreated water — so a rise in world prices, whether from global supply shortages or surging global demand, raises import-dependent firms’ costs of production. Defending their margins, firms cut output and pass costs forward: short-run aggregate supply falls and the general price level rises. A spike in world oil prices, for instance, feeds through to higher domestic energy prices for firms and consumers. The effect can compound: a higher cost of living prompts wage demands to protect real income, raising labour costs and shifting SRAS left again.

External cause 2 — rising external demand-pull inflation. When global conditions are buoyant, strong growth in export demand and inbound FDI raises aggregate demand. Because Singapore already operates near full employment and its productive capacity — constrained by low productivity and labour-force growth — cannot expand fast enough, the extra demand bids up scarce resources and the price level rises sharply.

Internal cause 1 — rising unit labour cost (cost-push). Domestically, cost-push inflation arises chiefly when wages rise faster than productivity. Tighter foreign-worker levies and quotas, intended to lift productivity, raise competition for scarce low-skilled labour in a tight market, pushing up unit labour cost across construction, marine, manufacturing and services. Because productivity-raising measures act only with a lag, elevated unit labour cost persists in the short run, lowering SRAS and raising the price level.

Internal cause 2 — strong private consumption (demand-pull). Favourable growth expectations raise expected future income, boosting consumption of big-ticket items such as housing and cars (reflected in firm demand despite high prices and COE premiums). With little spare capacity, the rise in demand-pull AD pushes the price level up sharply. Singapore’s inflation thus stems from rising AD outpacing slow capacity growth and falling SRAS, with both external and domestic forces at work.

Part (b)

Price stability — low, stable inflation within the central bank’s target — is the standing objective of the exchange-rate-centred monetary policy the Monetary Authority of Singapore runs, a modest and gradual appreciation of the trade-weighted dollar within an undisclosed band. The thesis is that appreciation remains the primary and most effective instrument against Singapore’s dominant inflation sources — imported and externally-led inflation — but it is not the best instrument against domestically-driven inflation, so for the next few years it must be supplemented, with the right supplement depending on the prevailing cause and the state of growth.

Why exchange-rate, not interest-rate, policy. With free capital mobility, MAS cannot independently set the domestic interest rate — Singapore is a price-taker — so managing the exchange rate is the feasible monetary lever.

Strength 1 — mitigating imported inflation. Because Singapore is so import-dependent, a gradual appreciation lowers the S$ price of imports, raising SRAS and letting firms pass cost savings to consumers, so the price level falls. A stable cost of living also lets wage rises track productivity rather than inflation, holding unit labour cost in check — addressing the wage-push channel indirectly. This directly counters the largest external source identified in part (a).

Strength 2 — buffering external demand-pull inflation. When the dollar appreciates, export prices in foreign currency rise; since demand for Singapore’s exports is price-elastic, export volumes are restrained, damping the excess AD that would otherwise cause demand-pull inflation near capacity.

Limitation — domestic supply-side and demand pressures. Appreciation does not address inflation driven by domestic factors — rising unit labour cost, rental, and strong domestic demand. As Singapore shifts towards labour-intensive services that gain little from cheaper imports, appreciation becomes less useful precisely where unit-labour-cost pressure is greatest. This is why other policies are needed alongside it.

Supplement 1 — supply-side policy for unit-labour-cost inflation. To tackle cost-push inflation from rising unit labour cost, supply-side policy raises productive capacity and productivity — private-investment incentives, skills upgrading (SkillsFuture), education and R&D (the Productivity Solutions Grant). Higher productivity eases the unit-labour-cost pressure that appreciation cannot reach. The qualifications are that productivity growth has remained stubbornly low despite these measures — arguing for deepening existing schemes (e.g. larger training credits) rather than proliferating new ones — and that supply-side policy acts only with a long lag.

Supplement 2 — contractionary fiscal policy for strong domestic demand. Where inflation is fuelled by strong domestic demand, a budget surplus — lower government expenditure with tax rates held — dampens AD growth, easing resource competition. Singapore’s recent surpluses fit its principle of accumulating reserves while growth is positive. But contractionary fiscal policy risks lowering growth and raising unemployment, and it is undesirable to run both a contractionary appreciation stance and a contractionary fiscal stance during weak growth.

Judgement. Exchange-rate appreciation should remain the centrepiece of Singapore’s price-stability framework, but it cannot be the sole — much less unconditionally the best — instrument over the next few years. The decisive consideration is the source of inflation read against the state of growth. Appreciation is the best instrument against the externally-driven inflation (imported costs, external demand-pull) that has historically dominated a small open economy, and there it should be retained. But the structural shift towards labour-intensive services and persistent unit-labour-cost pressure are domestic problems that appreciation cannot solve; these call for greater weight on supply-side measures to lift productive capacity. Fiscal contraction is available against strong domestic demand but must be used cautiously, never alongside monetary tightening in a downturn. The correct stance is therefore flexibility: lead with appreciation, but calibrate the supplementary mix to the dominant cause of inflation at the time. Given recent soft global commodity demand together with labour shortages and low productivity growth, the appropriate near-term emphasis is on appreciation and supply-side policy to relieve precisely those pressures — which is to say exchange-rate policy remains best-in-class for its target, but not sufficient on its own.